Beyond returns: How to factor in risk, liquidity and volatility to assess investment options

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Coach Dayal is putting together a cricket team for an upcoming inter-college match. What do you think is the first thing he’ll look for when he’s choosing his players? Ah! You guessed it right. Coach Dayal will first look at the runs a player scores, isn’t it? 

Drawing parallels, if you’re creating your investment portfolio, what’s the first thing that you consider when you’re investing? If you’re like most people, you’ll mainly focus on how much you can profit off your investment, isn’t it? In other words, this is the return on your investment and you’ll expect to maximise it as much as possible.

What are expected returns?

Simply put, they’re the returns that you’ll expect from your investment. For instance, say you have Rs. 10,000 and you’re planning to invest in the stock of Tata Capital today, with the expectation that it will increase by 20% within a year.

In this case, your expected returns will be 20%.

But what if you’re planning to invest your Rs. 10,000 in the stock of Tata Motors and Reliance Industries? Say, in the ratio of 50-50?

And suppose that you expect a return of 20% on your investment in Tata Capital and a return of 25% on your investment in Reliance Industries.

In this case, what will your expected returns be?

20%? 25%? Or both?

Well, that was a trick question! The answer is neither.

Here’s how you can find out the expected returns in this case. You need to multiply the proportion/weight of the amount that you invested in each investment with the expected returns for that investment.

Mathematically, this is how we express it.

E(RP) = W1R1 + W2R2 + W3R3 + ______ + WnRn

Where

E(RP) = Expected return of the portfolio

W = Weight of each investment in that portfolio

R = Expected return of the individual investment

Applying this formula to the above investment, we have

E(RP) = (50% x 20%) + (50% x 25%)

= 10% + 12.5%

= 22.5%          

Looking beyond returns: An introduction to volatility, risk and liquidity

The expected returns are indeed important. There’s no doubt about that. But should you pick an investment option simply because it has the potential to give you high returns? No, not really. Here’s where you need to assess three other important factors – risk, volatility and liquidity.

To understand these concepts better, let’s revisit Coach Dayal and learn what he has to teach us.

Volatility

The coach is now assessing the performance of two players, whose stats are as follows.

Match number

Runs scored by Player 1

Runs scored by Player 2

1

10

55

2

100

45

3

10

35

4

100

45

5

10

50

Total runs

230

230

Average runs scored

46 (230/5)

46 (230/5)

Coach Dayal is in a dilemma about which player to pick for his team. Player 1 and Player 2 both have an average of 46 runs each. But their individual scores differ vastly.

Player 1 has the potential to score 100 runs in a match, but there’s also the possibility that he scores much lower. Player 2, meanwhile, is more consistent. He may not be as good, but he’s more predictable.

So, what does Coach Dayal do?

Well, after a lot of thought, he picks Player 2.

Why, you ask? Well, that’s because Player 2 is more predictable and less volatile. Coach Dayal can easily form the rest of the team accordingly, since he has a pretty strong idea of how many runs Player 2 is likely to score.

This, you see, is what volatility is. 

Volatility in the stock market

In the stock markets, volatility refers to the changes in the price of a security or a stock over a given period of time. Frequent drastic changes in the price of a security mean that it’s more volatile (like Player 1), while infrequent minor changes in the price mean that it’s less volatile, (like Player 2).

This brings us to another important question – should you invest in a stock that’s more volatile, or less?

Well, there’s no right answer to that question. It depends entirely on your investor profile, what you want to achieve with the returns from the market and what goals you wish to meet. The important thing is that you assess and factor in the volatility of an investment before putting your money on it.

To assess the volatility of a stock or a portfolio, you have various mathematical formulas like the portfolio standard deviation.

Risk

Let’s take the same example of the two players and Coach Dayal once again. Previously, we saw that the coach picked Player 2 because he was less volatile. But say Coach Dayal is a risk-taker. He understands that Player 1 may be unpredictable in the way he plays the game. Nevertheless, he also sees that Player 1 has the potential to hit a century.

Weighing these two factors – the volatility of Player 1 and his ability to deliver 100 runs – Coach Dayal decides to take that risky chance and includes Player 1.

In this scenario, what exactly is this risk that we’re discussing? It’s the possibility of the player not performing well, isn’t it?

That’s just what the risk of an asset or a portfolio is.

Risk in the stock market

In layman terms, the risk associated with a particular investment is the probability of you losing money when you invest in that instrument. Risk can be of two types.

  • Unsystematic risk
  • Systematic risk

To understand this, let’s take another look at Player 1. Say he suffers a minor injury in his foot. This drastically reduces the chances of his scoring a century during a match, doesn’t it?

Now, let’s consider another scenario. Say the cricket team is all set to play a match in a new place, who’s playing conditions they’re not used to. In this case, there’s a high possibility that the team may not be able to give their best, since they’re not acclimatised to this new playing field. This factor also reduces the chances of Player 1 scoring a century during the match.

In both cases, Player 1’s chances of hitting a century are reduced. But what’s the difference in the two cases?

You see, in the first scenario, the reason for this risk lies with the player. That's an unsystematic risk.

But in the second case, it lies with external factors. That’s systematic risk.

Defining the kinds of risk

So, let’s define these two terms with regard to the markets and investments.

  • Unsystematic risk is inherently associated with a specific industry, segment or security.
  • Systematic risk is the probability of a loss associated with the entire market or the segment in which a company operates.

There are many numerical techniques to assess the risk of a security or a portfolio, like variance and covariance, variance covariance matrix and the portfolio standard deviation calculator. 

Liquidity

Alright then, you’ve seen what volatility and risk are. It’s time to look at the last element in the trifecta – liquidity. What is this liquidity, anyway? Simply put, it’s the ease with which you can convert an asset into ready cash, without affecting its market price.

Let’s look at two different investors and their choice of investment to understand liquidity better. 

Ram invested in real estate last year. To be more specific, he purchased a spacious villa on the outskirts of Pune in the hopes of renting it out and earning some passive income. At around the same time, Gaurav, Ram’s brother, invested in some physical gold. 

Today, one year later, Ram is still having a hard time finding a tenant for his property. And suddenly, there’s a medical emergency in their family and they’re in need of some funds. The two brothers are both willing to sell their investments in exchange for liquid cash. However, only one of them succeeds.

Well, there’s no prize for guessing which one it is. Gaurav, who invested in gold last year, readily found a buyer. Ram, on the other hand, couldn’t find someone to sell his property to at such short notice. 

What does this tell you? That in this case, gold appears to be more liquid than real estate, isn’t it? In other words, there’s always a ready market for gold. 

Like this, different investments come with different levels of liquidity. You’ll need to factor this in before choosing investments for your portfolio. 

The relationship between risk, volatility and liquidity

Are these three elements related? Yes, let’s see how.

Volatility and risk

  • The higher the volatility of an asset, the riskier it is as an investment option.
  • Conversely, the less volatile an asset is, the safer it may be to invest in.

Liquidity and risk

  • The more liquid an asset is, the less its risk, since it’s easier to sell off the investment.
  • Conversely, the less liquid an asset is, the riskier it may be to invest in.

Wrapping up

Looking beyond returns helps you make an investment plan that’s suitable for your individual investor profile. Keep going with Smart Money to read more about goal setting and financial planning based on your risk-return profile.

A quick recap

  • Expected returns are the returns that you expect from your investment.
  • To calculate the expected returns from an investment portfolio, you need to multiply the proportion/weight of the amount that you invested in each investment with the expected returns for that investment.
  • In the stock markets, volatility refers to the changes in the price of a security or a stock over a given period of time. 
  • Frequent drastic changes in the price of a security mean that it’s more volatile, while infrequent minor changes in the price mean that it’s less volatile.
  • In layman terms, the risk associated with a particular investment is the probability of you losing money when you invest in that instrument. 
  • Risk can be of two types: unsystematic risk and systematic risk.
  • Unsystematic risk is inherently associated with a specific industry, segment or security.
  • Systematic risk is the probability of a loss associated with the entire market or the segment in which a company operates.
  • Liquidity is the ease with which you can convert an asset into ready cash, without affecting its market price.
  • Different investments come with different levels of liquidity. You’ll need to factor this in before choosing investments for your portfolio. 
  • The higher the volatility of an asset, the riskier it is as an investment option.
  • Conversely, the less volatile an asset is, the safer it may be to invest in.
  • The more liquid an asset is, the less its risk, since it’s easier to sell off the investment.
  • Conversely, the less liquid an asset is, the riskier it may be to invest in.
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